Source memory, the ability to identify the context in which a memory occurred, is impaired in schizophrenia and has been related to clinical symptoms such as hallucinations. The neurobiological underpinnings of this deficit are not well understood. Twenty-five patients with recent onset schizophrenia (within the first 4.5 years of treatment) and twenty-four healthy controls completed a source memory task. Participants navigated through a 3D virtual city, and had 20 encounters of an object with a person at a place. Functional magnetic resonance imaging was performed during a subsequent forced-choice recognition test. Two objects were presented and participants were asked to either identify which object was seen (new vs. old object recognition), or identify which of the two old objects was associated with either the person or the place being presented (source memory recognition). Source memory was examined by contrasting person or place with object. Both patients and controls demonstrated significant neural activity to source memory relative to object memory, though activity in controls was much more widespread. Group differences were observed in several regions, including the medial parietal and cingulate cortex, lateral frontal lobes and right superior temporal gyrus. Patients with schizophrenia did not differentiate between source and object memory in these regions. Positive correlations with hallucination proneness were observed in the left frontal and right middle temporal cortices and cerebellum. Patients with schizophrenia have a deficit in the neural circuits which facilitate source memory, which may underlie both the deficits in this domain and be related to auditory hallucinations.